Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday 14 February 2014

Are New Keynesian DSGE models a Faustian bargain?

Some write as if this were true. The story is that after the New Classical counter revolution, Keynesian ideas could only be reintroduced into the academic mainstream by accepting a whole load of New Classical macro within DSGE models. This has turned out to be a Faustian bargain, because it has crippled the ability of New Keynesians to understand subsequent real world events.

Is this how it happened? It is true that New Keynesian models are essentially RBC models plus sticky prices. But is this because New Keynesian economists were forced to accept the RBC structure, or did they voluntarily do so because they thought it was a good foundation on which to build?

One way of looking at this (and I’ll argue at the end that it misses a key element) is to think about the individual components of models. If you do this, the Faustian bargain story looks implausible. Let’s start with the mainstream before the New Classical revolution. This was the famous post-war neoclassical synthesis popularised by Paul Samuelson, which integrated traditional Keynesian and Classical models in a common overall framework. While prices were sticky we were in a Keynesian world, but once prices had adjusted the world was Classical.

In terms of components, the RBC model is just the classical macromodel with two key additions. The first is rational expectations. The second is intertemporal optimisation by agents. (In non-jargon, it takes seriously the ability of agents to choose when they consume by saving or borrowing, rather than simply assuming they just consume a fixed proportion of their current income. This is often called the consumption smoothing model, because typically consumers smooth consumption relative to income e.g. by saving for retirement.) In both cases I do not think Keynesian economists were forced to adopt these ideas against their better judgement. Instead I think quite the opposite is true: both ideas were readily adopted because they appeared to be a distinct improvement on previous methods.

The key point here is that they were an improvement on previous practice. It does not mean that economists thought they were the final answer, or indeed that they were half adequate answers. Instead they were a better foundation to build on compared to what had gone before. I’ve argued this for rational expectations before, but I also think it is true for intertemporal consumption. I find it very difficult to think about more complex ideas, like liquidity constraints or precautionary saving, without starting with consumption smoothing.

I have talked about the real world events that convinced me of this, but here let me make the same point in a more informal way. When teaching on the Oxford masters programme, I give students a question. If they won a large sum, would they spend it over the next year, over the next few years, spend a significant proportion now but save the rest, or save nearly all. The last response is the answer given by the simple intertemporal model, but I argue that the first two responses make perfect sense if you are a credit constrained student. However I tell my audience that those who gave the first answer are not intending to do a PhD after finishing the masters, while those who gave the second are, because they are expecting the credit constraint to last longer. The serious point is that credit constrained consumers do not automatically consume all of a temporary increase in income. If the period over which income is higher is less than the period over which they expect to be constrained, they will smooth their additional consumption.

So, in terms of the components of New Keynesian models, I can see little that most modellers would love to junk if it wasn’t for those nasty New Classicals. [1] But what this ignores is methodology, and the fact that the RBC model is a microfounded Classical model. (By microfounded, I mean that every macroeconomic relationship has to be formally derived from optimisation by individual agents.) Yet here again, I doubt that most New Keynesian modellers adopted the microfoundations perspective against their better judgement. Instead I suspect most saw the power of the microfoundations approach (in analysing consumption, in particular), recognised the dangers in ad hoc theorising about dynamics (as in the traditional Phillips curve), and thought there was no contest.

The more interesting question is whether this has turned out to be a Faustian pact between macroeconomics and microfoundations ex post. To be more precise, by putting all our macroeconomic model building eggs in one microfounded basket, have we significantly slowed down the pace at which macroeconomists can say something helpful about the rapidly changing real world? That is a question I have written a lot about (e.g. here, and here) and no doubt will write more, but the key point I want to make now is this. If there was a Faustian bargain, I think we should acknowledge that most Keynesian economists agreed to it for good reasons, and that they were not forced into it by others.

[1] I must add a caveat here, although it is rather controversial. I think one sense in which RBC models have cast an annoying shadow is the idea that we must have models in which labour supply is endogenous. Often it would make things simpler if we could assume a fixed labour supply, and my own view is that for many issues we would lose little empirical relevance if we did so. Here I do think New Keynesians are too deferential to the always silly idea of trying to explain movements in unemployment as simply a labour supply choice.   


  1. But why start from a classical model? People who rejected the Faustian bargain, if that's what it was, generally didn't object to rational expectations, at least in principle, or intertemporal optimisation. The likes of Tobin, Hahn and Solow were quite receptive to that. (Didn't intertemporal optimisation start with the very Old Keynesian Franco Modigliani?) But an infinite horizon (as opposed to OLG, say) and Ricardian equivalence? What's so compelling about that?

    1. Could you clarify what "OLG" is? I've never seen that acronym in this context before. Thanks!

    2. OverLapping Generations. Simplest version: people live for 2 periods. They work when young, retire when old.

  2. DSGE has a lot of problems. It uses per capita income assuming the average is representative. In a subsistence, predominantly agricultural economy this maybe a silly position to defend. Most people are concerned about where the next meal will arrive. They are by no means "inter temporal optimizers". People in general rely both on past experience and future guidance from opinion leaders. They have different tastes, differing time preference rates, and often times diametrically opposite perceptions about particular issues. I can go on and on. DSGE is really silly for me.

  3. Microfoundations for macro is like quantum mechanical foundations for biology and psychology. Yeah, but...

    1. I don't think epistemological distance is a big problem so much as microfoundations represents one path (kinetic theory) and ignorance of microfoundations represents another path (thermodynamics).

  4. I have been playing around with Google ngrams after Krugman used it for the word 'loser' (January 13, 2014 'You’re All Losers'). There are more interesting words to try than that, and they impact on economics.

    Putting 'housing bubble' in British English 1800-2008 produces an astonishing graph, the same with American English. And I have found similar results for 'entrepreneur', and 'aspirational' in British English.

    Shiller's point has been that the language people use to describe what is going on in economics is critical, and it's not always rational. There is a cultural problem here, and the dotcom bubble and the housing bubbles are, or should be seen as, a connected revisionist event.

  5. To be more precise, by putting all our macroeconomic model building eggs in one microfounded basket, have we significantly slowed down the pace at which macroeconomists can say something helpful about the rapidly changing real world?

    The answer is of course yes. Macro-economics today is narrow minded, it believes itself above empirical evidence, not answerable to policy relevance and critical reasoning and has ignored the big intellectual debates that have been taken outside the discipline over the last half-century even though they are fundamental questions of methodology and good practice.

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  7. In a world of deterministic chaos and emergent properties, wasn't microfounded macro bound to be as useless as it has proven to be?

    Couldn't reason and prudence (pardon my plain English) have been accorded due weight without pretending that they were fundamental?

    Is NK any more than the addition of Ptolemaic epicycles to geocentric DSGE?

  8. Somehow, I don't think that asking Masters Macro-economics students at Oxford is a good reflection of average behavior regarding disposable income. I'm all for appreciating dynamic forces and how individuals and businesses (or groups) respond over time. However, the nature of what cues and how the response to those cues end is much more complex than the RBC community assumes, I'd venture. If consumers and businesses were rational lots would be different both for individual markets and in macroeconomic behavior. How otherwise can you explain a tendency to ignore risk in bubble formation, a demonstrative advantage to more than a minimally informative advertising campaign budget and that old people in the US get hoodwinked by politicians who actually want to cut their benefits.

  9. Don't be silly -- "old people [62+] in the US" know full well that no politician would dare cut their benefits. Young people who've been encouraged to believe that Social Security will run out of money when they're ready to retire (I know, silly but there it is) may wind up "hoodwinked."

  10. I'm going to comment without reading the entire post. I should start by noting a point of agreement. I think the most energetic and influential new Keynesians did not make a Faustian bargain. I think they loved the idea of models including agents with rational expectations. Greg Mankiw, at least, made that passionate devotion to RE very clear to me mostly in lectures but also (to drop names) face to face. I had less contact with Blanchard but the same impression. So not adopted "against their better judgment" but "according to their judgment".

    However, I absolutely disagree with your view that the new approaches adopted for non-Faustian reasons by New Keynesians were improvements on Keynes. Your accuse pre-new Kynesians of "simply assuming they just consume a fixed proportion of their current income." Keynes did not assume that. You assert that old Keynesians assumed that a model of consumption which is useful in macroeconomics is also useful in microeconomics. Keynes was an old Keynesian and this is what he wrote about the PIH
    "(6) Changes in expectations of the relation between the present and the future level of income. — We must catalogue this factor for the sake of formal completeness. But, whilst it may affect considerably a particular individual’s propensity to consume, it is likely to average out for the community as a whole. Moreover, it is a matter about which there is, as a rule, too much uncertainty for it to exert much influence."

    Note I assert that he considered and dismissed the PIH. The claim that it was a new idea in 1958 is demonstrably false (I do not, of course, claim it was new in 1936). Note also that he very explicitly argues that future income must be considered when studying individual consumption. As usual (always) Friedman made a strong case against a straw man. Keynes didn't need to be taught about saving for retirement. He argued that .. well it's cut and pasted above.

    I absolutely agree with " ideas were readily adopted because they appeared to be a distinct improvement on previous methods".

    I absolutely disagree with "The key point here is that they were an improvement on previous practice. "

    That is a claim which should be supported by evidence. I know of no evidence which supports your claim. I do not believe that there is a DSGE model which can fit aggregate consumption data as well as "previous methods".

    To be clear "previous methods" (including Keynes in the General Theory) include effects of financial wealth as well as income, so the ratio of consumption to income was predicted to be high when the ratio of wealth (not including human wealth) to income was high. But leaving that aside, I ask is there a DSGE model which fits aggregate consumption data as well as the model in which it is assumed to be a constant times personal disposable income ?

    I ask for information. If there isn't, this should be well known. I believe there isn't.

    Note I used the phrase "as well" not the word "better".

  11. I am still perplexed how microfoundations survived Kahnemann. The demonstrated truth that actual individuals, in certain circumstances at least, do not behave as rational utility maximizers should have unsettled the insistence that economic modeling proceed from the contrary assumption. But I'm the dumb guy in the conversation, so there's probably something I don't understand.

    I note what I believe is a non sequitur in Simon Wren-Lewis's narrative. As between the Keynesians and the Classics, prior to RBC the two schools were incompatible---there was no meaningful dialogue between them but only competition, and the experience of the Depression I think pretty clearly meant that the Keynesians won. So RBC, as an improvement over the old Classics in relatively minor fashion, from the perspective of post-Depression Keynesians, seems to represent a rather big step backwards---it was a compromised settlement of a fight the Keynesians had already won. So that's another thing I'm perplexed by.

  12. «The demonstrated truth that actual individuals, in certain circumstances at least, do not behave as rational utility maximizers should have unsettled the insistence that economic modeling proceed from the contrary assumption.»

    That's entirely irrelevant. As the central verity of Economics is that productivity justifies the income of the deserving rich, except for government distortions that redistribute to the parasitic poor, then only assumptions that lead to that verity are "realistic" and acceptable.

    Things like rational expectations and intertemporal optimization were designed to add assumptions that extended the verity of the neoclassical model to any time period, by essentially extending "tatonnement" to eternity (not just to infinite markets with infinite goods and participants).

    Put another way they were designed to wish away the outcome of the Cambridges capital controversy; because two of the crucial threats to the central verity of Economics are the existence of capital, and capital being "sticky", as they create path dependency across time, and thus multiple equilibriums with multiple distributions of income, each of which is hard thus to argue is justified solely by the superior productivity of the deserving rich. Sraffa's results, with multiple equilibriums in a comparative static setup, was simply ignored as too obscure.

    Time, capital and money are the fatal poisons to the central verity of Economics, and every effort must be made to cleverly expunge them from microfoundations, because they are not "realistic". :-)

    1. You're right. DSGE is much better at describing a world where there are no capitalists.

  13. I think you are ignoring selection here. The phd students and then successful academics that found micro-foundations interesting were selected to be the face of macro-economics. Those of us who went into graduate school interested in macro-economics but not in micro-foundations were told quite explicitly that there was no room for us. So I switched over to applied micro which is more data and story driven. Also, just anecdotally, hiring committees just did not offer jobs to people who were not doing micro-founded work.

    Macro drove out anybody who wasn't interested in doing micro-foundation work. Actually, worse than that, for a while most schools drove out anybody who was interested in anything other than the classical micro-foundations-which we now know are wrong in lots of cases.

  14. First, wages and prices fell during the Great Depression so the notion that wage and price rigidity is the source of the problem is ridiculous. Furthermore this was precisely the position against which Keynes argues in Ch.19 of the General Theory. So for the sake of historical accuracy we might wanna start calling New Keynesians anti-Keynesians.

    Seriously, if you start with Arrow Debreu, add rational expectations and expected utility you would have to add numerous market frictions to make this basic model even half-way realistic. As far as I know this is technically incredibly complicated (which is why basic DSGE used the short cut of Calvo pricing instead of the Blanchard/Kiyotaki approach to monopolistic competition; so much about rigrous microfoundations and having gotten rid of ad hoc) so why even try?

    If you start with Arrow Debreu and add one or two market failures you will naturally get fairly classical results. Stiglitz who worked on incentive issues due to asymmetric information wrote a bunch of macro papers around 1990 together with Bruce Greenwald in which financial market imperfections lead to "Keynesian" results. He modeled these incentive issues directly, MIT style, quick and dirty which is why the results are far better than those of the usual DSGE approach.

    In short, don't start with a perfect world and then slowly make it a little bit imperfect. Start directly with those imperfections.

  15. Very interesting. I would like to see (or if it doesn't exist, write) a history of how New Keynesianism replaced Old Keynesianism in the UK, where as far as I can tell there was never a very powerful monetarist counter-revolution (in the macroeconomics profession) and the Old Keynesianism was much closer to American Keynesianism circa 1944 than Samuelson, Tobin, Patinkin and the like.

  16. Joan Robinson referred to the vulgarisation and debasement of the General Theory. People putting into a General Equilibrium framework should be warned.


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